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Paul and Brett's Alpha

April 2022

Sisyphean dissipations

Keeping one’s spirits elevated can be a challenge during times like these. It does rather feel that, as soon as we believe we are on top of the latest geopolitical or macroeconomic crisis, another comes along. Whilst us ordinary folk are victims of circumstances largely beyond our control, to our minds most of these crises are the product of a combination of poor leadership and an inability of people in power to admit when they are wrong or do not know something. As a consequence, the many and varied travails of our global village feel like they were eminently avoidable.

Is there really any logical need for China to sacrifice its economy and the (limited) freedoms of its populous just so an autocratic despot doesn’t have to admit that Western vaccines are better than Chinese ones and ‘Zero COVID’ is utter nonsense? Does Ukraine need to continue to suffer because one ex-spy cannot admit that his country is no longer a superpower, despite the fact that hardly anyone in Russia other than him seems to care?

Whilst these political chess games continue, rapidly rising food and fuel prices, concordant with the Federal Reserve hurtling toward meaningful US interest rate rises (we doubt they will fully come to pass, but that’s a topic for another day), increases the risk of another 1998-style emerging market debt crisis, with all the attendant human suffering that would bring.

“The West” can hardly proclaim intellectual superiority or moral leadership though: the last US election was a choice between a liar and someone who appears to have been happy to let his son peddle influence and access whilst he was VP and is rather prone to gaffs that suggest his grasp of, well anything, is far from optimal. France has just re-elected an unpopular president by a limited margin because he was deemed a less offensive choice than a neo-fascist. Indeed, illiberal political movements seem to be gaining ground everywhere. Isn’t democracy wonderful?

Nor can “The West” hold the moral high ground on not invading or destabilising other sovereign countries because we do not like their leaders, or having some red line about not dealing with despotic regimes that oppress their peoples. If you have enough natural resources, then a blind eye is turned. The Americans going cap in hand to Venezuela and Saudi Arabia is surely evidence that principles are indeed a relative construct in realpolitik. It really is quite difficult to remain an optimist or an idealist amidst all of this horse-trading.

Here in the UK, we have a familiar-sounding Hobsonian choice of sticking with a liar or going with someone who does not really seem up to the task and who himself only got the job as leader of the opposition because he was not an unelectable Trotskyist. Recent news stories also confirm that the opposition is not above telling a few porkies for political advantage and then are incapable of apologising when caught out.

At least the UK has a third national party… as a bit of fun, can any readers recall who the leader of the Lib Dems even is, never mind what they look like? The party does still exist, we checked; they have policies and everything and still have 2% of the seats in the Commons. They say we get the leaders that we deserve. Your managers have been wracking their brains but we really cannot recall doing anything so awful as to deserve this deluge of effluent.

Why make these obvious observations, save for the often cathartic release of venting one’s frustrations by stating that which is self-evident?

Firstly, it has relevance to the macro backdrop: it seems reasonable to assume that the many and various issues the world currently faces are not going to get better quickly with any of these idiots in charge. Moreover, the absence of compelling alternatives to the aforementioned ‘leaders’ does not augur well; the least-worst option seems to be the devil you know. In conclusion then, the emergence of a definitive post-COVID world order is going to be a challenging birth and any near-term hope for a stable geo-political backdrop is forlorn. The markets are adjusting to this but further volatility clearly lies ahead.

Secondly, we come back to the initial observation. Many of these problems stem not only from bad decision making, but from the failure to recognise this and to change course when it becomes glaringly obvious that is what needs to happen (yes Rishi, this includes you). Sometimes, when things are going wrong, it can be hard to be objective and ask the most difficult question: am I doing the right thing?

Epistemological equanimity

One of life’s great paradoxes is that self-reflection is not easy whilst cognitive dissonance and self-delusion are disturbingly straightforward. There is all manner of psychological research showing that we imbue our decisions, and the supporting evidence for them, with greater weight over time and tend to ‘double down’ in the face of even logical questioning of previous decisions (cf. the ‘backfire effect’, ‘endowment effect’ and the ‘mere exposure effect’).

When it comes to investing, admitting you are wrong having lost money and “cutting your losses” is really tricky for most people too (cf. ,the ‘break-even fallacy’, ‘sunk cost fallacy’ and ‘loss aversion’). We say these things from experience: our own data shows us that we are seldom aggressive enough in exiting a position when the investment hypothesis suffers a major setback, but there again everything appears clearer in hindsight.

However, the key to all of this is continuous self-reflection. We fully recognise that we make mistakes and we try to do better. That is why we believe that a co-management structure is the best approach to running a fund. It is much easier (and more fun) to play devil’s advocate and take the other side of an argument and have a debate about the merits (or otherwise) of a thing than to review it on your own: this is why newspapers have editors and accounts have auditors.

If, in the end, one can come away from such a discussion happy to continue to have a position because it has stood up to the scrutiny, then you are all the better for it. In doing so though, one must recognise that the past is irrelevant. The only thing that matters is where you are today and what you think will happen in the future.

The last six months have not been easy for us, or satisfying in terms of the investment return outcome. Over this period, the Trust’s sterling NAV total return has been -16.4%. The mega-cap MSCI World healthcare Index has returned +4.0%. Context is everything though; the Nasdaq Biotech and Russell 2000 (i.e. mid-cap) healthcare have returned -17.7% and -30.9% respectively.

As our readers should be aware, the outcome of our investment philosophy is that we will tend to have more mid-cap and more focused/operationally-geared companies. These are going to be more volatile and deliver less correlated returns than a strategy running a lower active share. When assessing our performance then, we need to be mindful of these more SMID-focused comparators and, with so many similar healthcare stocks down well into double-digits over this period, our return is explainable.

This does not make us complacent. We pore over every element of the performance attribution trying to understand the whys and wherefores of our outcomes. For instance, we have chosen to be levered throughout this period. Since leverage exacerbates directionality, this has contributed to our under-performance because the market has continued to fall. This analysis seems as obvious in its conclusions as it is simple in its mechanics, but the reality is more nuanced.

Our use of leverage is timing-related and drawing down funds enables us to take advantage of mis-pricing events, allowing us to increase exposure to shares when their prices fall significantly. These “oversold” situations often ameliorate quite rapidly, permitting us to make a positive return on these trades. The ungeared open-ended version of the strategy offers a guide to the ungeared returns of the portfolio.

If one compares the total return of the two products over the six month period, the WS Bellevue Healthcare Fund’s total return is only about 100bp higher than that of the Trust (i.e. the geared version), so the negative contribution of our leverage on overall performance has been very muted. However, it has allowed the Trust to obtain higher levels of gross exposure to the companies we like at very attractive prices, which we think is to our advantage in the longer-term.

Again though, context is key. If we look at the first five months of the same period of data to the end of March 2022, the return of the Trust was actually higher than the Fund, i.e. one can conclude that being levered had not adversely impacted our performance despite the overall direction of returns still being negative. Put another way, it only really hurt us in the carnage of April.

The fundamentals of the portfolio remain positive and the valuations of the companies with it compelling when viewed over a longer-term horizon. It is this opportunity that prompts us to continue to put capital to work. In any rational universe, these are beguiling entry levels.

The anatomy of an upturn in the context of a downturn

If one begins with the (admittedly questionable) premise that the equity market is, in the end, a rational valuation mechanism, there are three fundamental reasons why shares will increase in value:

  • earnings growth is realised as time passes. If the market is happy to pay 10x current earnings and the earnings in three years’ time are higher than today, then it follows that the share price will also be higher in three years’ time, even if the FY3 earnings forecast does not change over the three years in between. 
  • the earnings outlook improves. If the expected earnings forecast in three years' time begins to look too low, then that same earnings multiple will be applied to a bigger number and the shares will go up.
  • the market chooses to apply a higher multiple to forward earnings and the share price rises without the earnings outlook changing at all.

All of the above phenomena work both ways, so all can contribute to shares declining. Indeed, on the downside they are often linked. If a company announces a surprise negative development, it will impact the earnings outlook and at the same time, the attendant uncertainty over the future outlook suggests it is prudent to apply a lower multiple, which is why downside moves can be so material on unexpected announcements.

This rather begs the question: what has driven the downside to the Nasdaq Biotech and Russell 2000 Indices? Clearly at a company-specific level, any combination of these can come into play and there have undoubtedly been a fair share of material setbacks for companies over this period.

If one were to look at the EPS trend of each index over the period (and focusing on the same earnings year – 2023), Bloomberg data suggests that the overall trend has been a modest positive one for both indices. Ergo, the overwhelming driver of the deterioration in share prices has been a reduction in the rating.

Despite a de-rating being the primary reason that we are where we are in terms of net asset value and investor returns, this does not mean that we are dependent upon a re-rating to deliver future returns for investors. If the collective wisdom of the stock market opines that the current multiples are the correct ones for the next few years, we still have underlying double-digit growth in our companies (even on a risk-adjusted basis) to fall back on. When stock-level fundamentals do return as the driver of share price performance, we should be well rewarded. If there is a re-rating to boot, then all the better.

Defending the defensive

One of the interesting things about being a portfolio manager is that investor questions in meetings offer a mirror into the thinking of the market; we can learn as much about the perception of the market from these interactions as we can from our spreadsheets and models of sub-sector performance and factor behaviour.

We have seen more investors face-to-face in the past six weeks than we have in the preceding two years. We are very happy to be back on the road meeting people and it became obvious very quickly how inferior virtual interactions are when compared to the real thing. Over the past weeks, there has been a noticeable increase in the level of questioning regarding the pervasiveness of defensive growth characteristics within the sector. To the extent one can generalise, the question is along the lines of “do the other sub-sectors and smaller companies have the same level of earnings defensiveness as Large-Cap pharma?”.

The mere fact people are asking this question is almost as interesting to our minds as the answer to it. Firstly, we see it as clear evidence that people want to hide from an unfriendly world in the relative comfort and safety of something they perceive to be low risk. This is understandable. The large pharma companies are generally well diversified so that, even if there is a hiccup in the pipeline, it will not tend to move the earnings needle over-much, leaving one’s capital at limited downside risk.

They are not bulletproof though, as Roche’s recent pipeline failures and cuts to FY22 guidance from Abbvie will attest. Meanwhile, Pfizer continues to generate around half of its revenues from COVID-19 vaccines and treatments.

Setting aside size-related diversification, the more interesting aspect of the question to our minds is the perception (or worry) that other areas of healthcare might be less defensive. Granted there are some areas where the consumer is paying and there are opportunities to forego treatment or trade down (e.g. wires and brackets instead of clear aligners, or having less frequent cosmetic treatments, although there is little evidence for the latter from Abbvie’s Q1 results), but the vast majority of healthcare treatment is driven by need not want and so there is little reason to be more concerned about the outlook today than six weeks or six months ago.

We could also understand some reticence on this topic in early 2020, when the pandemic was in the ascent. At that time, hospitals were postponing procedures and consumers were avoiding the doctor and the dentist if they could bear to wait. Roll forward to today though, and the opposite is happening. Procedures are opening back up and patients are trying to come back, such that available capacity is being filled (capacity is still not back to normal due to ongoing COVID protocols and staffing issues, but it is improving not worsening).

Sadly, the only way to assuage this perception is to continue to deliver a robust operating performance and then, in time, confidence should improve. This is frustrating for sure, but on the other hand, it creates an interesting opportunity to buy shares at attractive valuations and, in effect, be paid to wait out the realisation that the broader market dynamic for healthcare is robust and those defensive qualities apply far more widely than current perception would lead you to think.

The most simple way to answer this question is with another question – have we negatively revised any of our longer-term growth expectations for specific sub-sectors of the healthcare ecosystem over the past six months? The answer is no. Quite the opposite in fact…

We always appreciate the opportunity to interact with our investors directly and you can submit questions regarding the Trust at any time via:

shareholder_questions@bellevuehealthcaretrust.com

As ever, we will endeavour to respond in a timely fashion and we thank you for your continued support during these volatile weeks.

Paul Major and Brett Darke